During the more than 10 years I spent on Bay Street as a technology analyst, I had a front-row seat on how the investing industry manages money.

I departed the Street knowing that I would never run my own portfolio the way that the investing industry handles clients’ money. The design of the industry exerts a constant drag on the returns you can expect.

Strategy Lab

Strategy Lab

Strategy Lab

One simple example of that drag is the fees charged by actively managed mutual funds. Those levies take a big bite out of your returns. Andrew Hallam, the millionaire teacher and a fellow Strategy Lab contributor, has written compelling articles demonstrating that actively managed funds underperform a broad stock market index. He’s right.

Unless you’re particularly lucky in picking the right fund, you’ll earn a better return in a low-cost index fund than in a managed fund. I believe do-it-yourself stock pickers who take a long-term perspective can also outperform most pros.

What causes actively managed funds to underperform? It’s not just the management expenses that get passed down to investors. Three other forces also pull on professional money managers, tilting them away from doing what is right for long-term clients.

1. The measurement period

Mutual fund managers tend to be measured on how they finish the year. This practically forces fund managers to take a short-term perspective on stocks. What happens next year or a couple of years down the road isn’t going to affect their ranking.

As an equity analyst covering the technology sector, my clients were fund managers. I never had a client whose compensation was tied to long-term performance. When you think about it, that’s rather amazing – the thing that matters the most to a fund’s most loyal clients is not rewarded.

2. The bonus bias

In the money management business, an annual bonus is a big part of your compensation. For “sell-side” analysts – those working for brokerages and research firms – the bonus is often several times your base pay. For “buy-side” managers (the people who run mutual funds, for instance) the bonus is lower, but can still be more than 100 per cent of base salary. Bonuses of that magnitude are a huge motivator and can sway decisions.

In many cases, the bonus you can earn is capped, meaning it can’t go above a certain level. So imagine the fund manager who had an exceptional first half of the year. Do you think he might be inclined to play it safe for the next few more months and spend more time on the golf course? Duh. Of course, he would. Why risk the bonus he already earned?

Now imagine the opposite. What happens to a fund manager who had a horrible first half of the year? He often takes more risks, hoping to make up for his mistakes in the second half.

3. Migrating managers

People move around a lot in the investing business. When a fund manager or a sector manager moves to a new job, someone else comes in to take her place. The old and new manager may not agree on past decisions. This triggers trading. Unless you can be sure that a fund manager will be in place for many years, you’re bound to have excessive trading – and trading costs money. This depresses your returns.

Add in the cost of trading with the other factors I’ve mentioned above and it’s easy to understand how a typical stock fund can turn over more than half of its assets each year, with no real benefit for investors. Most managers are more concerned about massaging their portfolios for short-term performance than buying and holding stocks that can produce market-beating long-term returns. Many money managers recognize the design flaws in the system. But there isn’t much they can do about it. Individual investors, though, always have the option of taking another route. When you understand the flaws in the industry, and how they work against the investing public, you start to appreciate the benefits of doing it yourself.

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